Business Valuation and Divorce – Tis The Season

Regardless of your profession, we have a few common denominators: Patriots Tampa Bay will be playing football, the Ground Hog will be wrong, and a goodly number of our clients will be getting divorced.

That’s right- family law practitioners know this well, and the statistics bear it out the end of January is officially divorce season.

With that in mind, what better time to cover some basics on valuation matters related to divorce?

Allocating Assets in a Divorce

It’s no surprise that one of the most contentious matters in divorce proceedings is the division of assets.  Understanding the value of brokerage accounts and a house tends to be relatively straightforward.  The value of a privately held business, on the other hand, is not nearly as transparent.  No wonder that this facet of the divorce process is confounding.

When to Hire an Appraiser

A refrain we often hear is that a business appraisal is too expensive, with the couple facing the financial constraints of a divorce proceeding.  And there is undoubtedly some threshold number where parties are best suited to stipulate to a value rather than undertake the expense of an appraiser.

On the other hand, as the probable value of the company increases, the need to hire a qualified appraiser is amplified.  In all likelihood, the parties involved do not have the experience or skillset to have a solid understanding of the asset’s potential value.  This makes it challenging to negotiate towards an agreed to value successfully.  In our experience, parties tend to drag out negotiations- making unrealistic offers far from potential value – to cause significant stress and ultimately increase costs.

Hiring an appraiser earlier in the process creates a “middle ground” and facilitates a more effective negotiation.

Standard of Value

At the outset, it’s essential to understand the appropriate “standard of value” to apply. Expected standards of value include “Fair Market Value” (the one that people are perhaps most familiar with), Fair Value, or “value to the holder.”

Fair market value is commonly defined as  “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, and both parties [have] reasonable knowledge of the relevant facts.”  Under fair market value, many appraisers apply discounts, such as the discount for lack of control (DLOC) and discount for lack of marketability (DLOM), to obtain the value of minority interests.

On the other hand, Fair Value often precludes the application of discounts.  Ultimately Fair Value is a statutory term, though, and subject to interpretation by the jurisdiction in which the matter falls.

The difference between these two value standards can be as significant as 40% – so a solid understanding of the appropriate standard of value to apply is critical.

Personal vs. Enterprise Goodwill

First, some definitions.  Goodwill is “blue sky” value – an intangible asset arising from the name, reputation, customer loyalty, location, products, and similar factors not separately identified.  Quite simply, it is the value of a company over and above its tangible net worth.  Here’s where things get tricky:  goodwill can arise from factors explicitly related to the business entity, or it can arise from factors related to an individual.  The distinction is enterprise goodwill vs. Personal goodwill.

This distinction has no bearing in some states – all goodwill, regardless of type, is a marital asset.  However, other states (the majority, at 32) have taken the position that personal goodwill is not divisible.  It belongs to the person, not to the marriage.

Thus, when appropriate, the appraiser is charged with teasing out the value of personal goodwill from the entire company’s value, as that portion is not a marital asset.

Note:  BVR has a handy guide to the treatment of goodwill by state here.

The Low Down on Discounts

First, what are “discounts”?

Privately held companies are different from public companies in various ways.  One of the most obvious ways is that there is no ready market for a privately held business stock.  As an owner, the time to liquidate shares isn’t measured in minutes but often in months or years.   This is especially true for minority interests – who wants to own a small piece of a highly illiquid asset?  To account for this time-to-liquidity, appraisers often apply a Discount for Lack of Marketability (“DLOM”).

Similar to the DLOM, another issue is related primarily to minority interests: as a non-controlling owner, what ability do you have to influence the company’s strategic direction?  Can you make changes to salaries that impact cash flows and dividends?  Can you encumber the company?  Can you sell the entire entity?   When a majority owner can do these things, it creates considerable uncertainty for minority interests holders.  Appraisers will often apply a Discount for Lack of Control (“DLOC”) in such situations.

These two concepts come into play based on the standard of value applied as discussed above.  With a combined discount often approaching 40%, it’s clear that this is a critical area of consideration.

Double Dipping

The concept of “double-dipping” often arises in divorce matters. Double-dipping refers to the idea that a spouse may be awarded twice:  first in the division of assets (income generated by the business included in the value of the asset), and again when calculating income available for support. The basis of the argument against double-dipping partially lies in how a business is valued.

An appraiser may use many approaches or formulas to determine the value of a company, several of which rely upon the company’s earnings stream.  The problem arises when an owner’s compensation is significantly more than the market rate for the position. This is a frequent occurrence.  As a single-owner company, the decision to allocate earnings between profits and salary is often discretionary- often resulting in a “dividend in disguise.”

The appraiser will commonly “normalize” salary to a market rate for the role to account for this.  In doing so, the value of the business will, in turn, increase as we are now looking at a more accurate, albeit it increased, level of profitability.  On the other hand, the salary used for calculation should be the “adjusted” salary – not the actual.  Where support is based on the existing higher wage, the recipient would benefit from the higher entity asset value and the higher income stream (hence, double-dipping).

What is collaborative divorce?

Thanks to myriad courtroom dramas, we often think of divorce as high stress, high cost, and high conflict; that’s not always the case in the real world.  Couples that adopt this process can often save high costs to include in the valuation process.

Collaborative Divorce is a legal framework that allows couples who have decided to separate or end their marriage to work with their attorneys and advisors while avoiding the uncertain outcome of court and negotiating towards a settlement that best meets the specific needs of each party.

In a collaborative environment, parties can agree to retain an expert jointly.  The valuator is then charged with “pitching it across the center of the plate.”  By having a single expert working on behalf of both parties, the expert can help educate everyone on the various issues related to the valuation without the appearance of a “hired gun” mentality.

In Closing: Valuation in the Divorce Process

One of the more complex issues many divorcing couples face involves the valuation of businesses and business interests that are marital estate property. Conducting a business valuation requires a variety of analyses, including examination of the economic environment, industry developments, and the unique attributes of the business being valued. These questions must be answered in all divorce situations. Still, when a business appraisal is conducted in conjunction with a collaborative divorce, it is fundamentally different from one carried out in a more adversarial divorce setting.